The shortcomings of industrial policy[1] do not lie on whether the government should be involved but rather on how the government should run its policies. Doing away with public funding or macroeconomic stabilization is not the solution. Instead, the appropriate mix between public and private pension systems and the correct approach to counter-cyclical fiscal policy must be established. It is more productive to focus the discussion on how industrial policy should be carried out than on whether it should be carried out at all. Industrial policy must not be hindered because of political issues or lack of information. It suffices that institutional solutions to agency problems are implemented.
The Strong Case for Industrial Policy (in Theory)
There is no doubt that market imperfections that urge industrial policies exist. Market imperfections reveal what it means to be underdeveloped and as the reason for why economic development is not an automatic process. Development is about structural change; in producing new goods with new technologies; and transferring resources from traditional activities to new ones. It is a process that has the potential to resolve many market shortcomings. Investment in new industries requires finance, but is very risky to private lenders and offers no track record. The problem with poor countries is that they do not work as well as they could to foster the structural transformation that is needed.
Government and institutional failures in protecting property rights and enforcing contracts are also a significant problem. But even when institutions are adequate, market imperfections will remain. “Good governance” must be in place to generate and implement the required policy initiatives to relieve the effects of market imperfections.
The strong positive relationship between the level of the real exchange rate and growth (Rodrik 2007) reveals the mechanics of economic growth and the rationale for industrial policies. Countries that manage to raise the real exchange rate grow more rapidly. For countries like Korea, Taiwan, and China, growth was led by a rise in the undervaluation index for their currencies. Developed countries do not share this relationship, indicating that the growth-promoting role of high real exchange rates applies only for low-income economies. This suggests that there is something noteworthy about tradables in these settings.
There are two explanations for this phenomenon: First, tradables suffer from the market failures that block structural transformation and economic diversification. Second, they suffer from the institutional weakness and contracting incompleteness that characterize low-income environments.
Industrial policy sceptics often recommend the implementation of horizontal policies rather than preferential ones. But, horizontal interventions are a limiting case and not a definite alternative to sectoral policies. Policy makers should not neglect the asymmetric effects of horizontal interventions. They need to make sure that the activities being favoured are those that really suffer from the market imperfections.
Governments often show that they are aware of the specific private needs and public inputs, even when they claim that they do not use industrial policies. However, some of them still engage in active industrial policies by providing public inputs that benefit only some particular economic actors.
The Ambiguous Case for Industrial Policy (in Practice)
The objections to industrial policy are twofold. First, it is impossible for governments to precisely identify the relevant firms, sectors, or markets that are subject to market imperfections (informational objection). Second, industrial policy is an invitation to corruption and rent-seeking. It becomes easy for the private sector to demand benefits from the government once it has provided support to firms; this may distort competition and transfer rents to politically connected entities. These issues are so important that the debate on industrial policy often revolve around conflicting views regarding the importance and pervasiveness of the said obstacles.
Can Empirical Work Help Us Sort It Out?
Proponents of industrial policy rely on the case evidence, pointing to a number of instances where government support seems to have nurtured successful world-class firms in developing nations. Opponents rely largely on cross-industry econometric studies, which seem to suggest that traditional industrial policy instruments do not generate the productivity benefits they seek to achieve.
There are a number of cases showing that industrial policy resulted in low-productivity, uncompetitive enterprises that never operated at full capacity. There are also cases showcasing their success. However, the cases do not settle the debate. One problem is the lack of an explicit counterfactual. It is possible that many of the successful industries would have come out even better in the absence of government support. Conversely, many projects that appear to have been failures can look better if the social opportunity cost of labor has been sufficiently low.
Case studies can take us only so far. They are just an examination of a specific policy in a specific setting and they are subject to selection biases. Authors are more likely to select and proceed with cases that confirm their priors. It is also not clear that their lessons can be applied to other locales, let alone to other types of policies.
One test whether industrial policy is effective is to correlate measures of economic performance for individual industries with measures of government support along with a number of covariates to control for other determinants of sectoral performance. The general approach is to run a regression.
Such econometric studies have problems of cross-sectional growth empirics, including those due to linear specification, omitted variables, measurement issues, and so on (Rodriguez 2006; Durlauf, Johnson, and Temple 2005). One dilemma is that the key estimated coefficient for the applied industrial policy cannot be distinguished between two radically different views of the world. Several subsequent studies have been performed but cross-industry studies are still uninformative. They are likely to remain so no matter how much the specifications are modified.
The results rule out some of the more extreme assertions about industrial policy. It gives us reasons to discount the view that it has had a damaging effect on growth and productivity compared to hands off strategies, even when it was badly carried out.
Industrial Policy in Practice: Some Country Vignettes
Experiences from El Salvador, Uruguay, and South Africa show the diversity of approaches that were used in different countries. It can also be observed that industrial policy is a major issue in many countries. The challenge in countries like Uruguay and South Africa is not to embark on new industrial policies, but to modify and improve the existing ones. El Salvador and South Africa have yet to reach their peak income levels from the late 1970s and early 1980s, their growth since the early 1990s seems weak. Uruguay had more rapid growth in the 1990s along with Argentina.
El Salvador
The problem with El Salvador seems to be the disjuncture between an economy that is badly in need of diversification and the very few entrepreneurial incentives to invest in new areas. Hausmann and Rodrik (2003) noted that El Salvador seems to be caught in a classic self-discovery trap. This is further aggravated by an overvalued currency and unavailable exchange-rate policy to cause an increase in competitiveness. The only success it has in recent years has been the maquila sector, which operates under a special tax regime and benefits from trade preferences granted by the United States. However, this sector has been insufficient to make up for the loss in traditional exports.
Salvadoran economic strategy was based on the idea that stimulating economic growth only requires fundamentals to be in order. Growth, under this view, is an automatic process, coming into its own in full force once the government removes imperfections. The disappointing outcomes have forced the present administration to re-evaluate this view and take a more pragmatic, hands-on attitude.
Hausmann and Rodrik (2005) listed design features for new industrial policy arrangements: the need to limit incentives to “new” activities, the use of automatic sunset provisions, the
establishment of clear benchmarks for success of programs, the reliance on agencies with demonstrated competence and a degree of autonomy from daily politics, the identification of a high-ranking political principal with “ownership” of the industrial policy effort as a whole, and the systematic use of deliberation bodies that engage the private sector.
Concrete programs that will illustrate the type of activities the government might engage in include:
· A co-financing facility to subsidize the costs of “self-discovery.”
· Redeployment of the public Multisectoral Investment Bank (BMI) as a public venture fund engaged in risky investment finance.
· The establishment of forums where businesses and sectoral associations come into regular dialogue with the government, with the purpose of identifying investment opportunities that might otherwise fall prey to coordination failures.
The government of El Salvador has long been hostile to industrial policy. It must change its attitudes and send the right signals to the private sector. If investors see that the government is willing to listen and help find solutions to their problems, the benefits can be huge.
Uruguay
Uruguay has extensive industrial policies even though it is hidden from view or not talked about much by policy makers. The results, however, are diverse. Some of the efforts work well while others are designed poorly. It is also surprising that rent-seeking, which is normally associated with industrial policy, is absent. This is important as it suggests that an authoritarian state may not be necessary for running industrial policies.
Uruguay has been recovering well from its recent crisis. Unlike in El Salvador, the private sector is aware of and interested in investment opportunities in different tradable sectors. On the other hand, the public sector has also played an important role in providing key inputs and support for new economic activities.
Uruguay is good at providing public goods like: a competent and honest bureaucracy, public safety, law and order, health and sanitary standards, research and extension services in some agricultural areas, functioning democratic procedures, and social cohesion. Hausmann, Rodriguez-Clare, and Rodrik (2005) argued that these assets can be used more effectively in producing renewal and economic diversification. Uruguay’s considerable institutional strengths must be targeted more closely on productive transformation to sustain growth.
The Uruguayan incentives were not well targeted on the important market imperfections. In addition, they were not based on performance standards, and tended to employ a restricted range of instruments that were specified regardless of the nature of problems. Uruguay obviously lacks a unifying vision. No high-ranking political official takes care of economic restructuring and diversification. Investment remains a product of the policy environment as inflation and public finances are. These result to poorly targeted programs that have varying effectiveness, and are not regularly evaluated.
South Africa
After South Africa made a transition to democracy, the economy fell short of achieving rapid growth. It generated few low-skill jobs and unemployment rose to very high levels. The tradable sector shrunk due to the loss of employment in mining and the slow increase in demand for labor in manufactures. This pattern of structural change caused a decline of demand for unskilled labor. Significant real currency depreciation could have helped revive demand for labor. But even though the currency experienced some depreciation in real terms, the effect on tradables was largely cancelled out by trade liberalization and other competitive forces acting on them.
To address this, the South African government recently launched the Accelerated and Shared Growth Initiative for South Africa (ASGI-SA), which placed industrial policy at the heart of the agenda. The government is currently formulating an industrial policy that will counter the negative trends it is experiencing and strengthen the manufacturing sector and expand other non-traditional tradables.
The Department of Trade and Industry (DTI) is developing the Customized Sector Programs (CSPs) to formulate policy initiatives for individual sectors. It revolves around dialogues between DTI and private-sector associations, and they cover a wide range of sectors. Meanwhile, the Motor Industry Development Program (MIDP) was developed for the auto industry to create a solid base of vehicle assembly (although the domestic supplier links remain weak due to upstream and downstream investment coordination). Other parts of the public sector are involved as well like the Department of Public Enterprises (DPE), the Department of Minerals and Energy, the Industrial Development Corporation (IDC), and investment promotion agencies of the government.
There is a tension in the current efforts between two different modes of carrying out industrial policy. One is the traditional, East Asian style where the government picks certain sectors and helps them through incentives. This model is defined by policy instruments and sectoral priorities. The other approach views industrial policy as a process without a preconceived list of sectors and policy instruments. The emphasis of this model is on constructing an institutional framework that investigates the problems and their remedies through dialog with the private sector. The South African industrial policy regime has been slowly moving towards the second model.
The second model solves some of the traditional problems of industrial policy, but brings out new ones. Hence, the institutional framework must be designed carefully to make sure that there is a constructive dialog between the private sector and the government, information flows effectively in both directions, needs are well identified, policy instruments are targeted, and self-correction mechanisms are employed.
South Africa also deals with the tension between the conduct of monetary policy and the condition of the tradables sector. Its inflation targeting framework causes an appreciated currency and this increases the premium on industrial policies. In effect, if there is less room for maneuver on the exchange rate front, there will be a greater need for a compensating industrial policy.
Institutional Design Features for Industrial Policy
The theoretical justification for industrial policy is relatively strong. However, the empirical evidence on whether industrial policy works on average is inconclusive. Although the specifics of industrial policy vary for each country, there are still general principles that specify how industrial policy should be designed. These principles follow from these considerations:
1. Embeddedness. The required knowledge about spillovers, market failures, and constraints that block structural change are circulated within the society.
2. Carrots and Sticks. Businesses have strong incentives to “game” the government.
3. Accountability. The intended beneficiary of industrial policy is neither bureaucrats nor business, but the society as a whole.
Embeddedness
An industrial policy that is conscious of the government’s lack of omniscience has to be constructed as a system of discovery about all sources of uncertainty. Mechanisms for eliciting information about the market constraints are required. Sociologist Peter Evans (1995) called this “embeddedness.” He showed that the success of Korean industrial policies was due to an autonomy qualified by being embedded in private-sector networks (embedded autonomy).
The right model for industrial policy lies between strict autonomy and private capture. It must be a model of strategic collaboration and coordination between the private sector and the government, whose goal is to reveal imperfections, design effective interventions, evaluate outcomes, and learn from the mistakes in the process.
Specific measures that can serve to achieve these ends include the establishment of deliberation councils, supplier development forums, “search networks,” investment advisory councils, sectoral round-tables, and private-public venture fund. Romer (1993) also proposed to set up “self-organizing industry investment boards”, which are collective organizations of firms aimed at providing specific public input to their industry.
This way of thinking treats industrial policy as a process of discovery that focuses on learning and getting information on the private sector’s willingness to invest subject to the removal of imperfections. It is from this process that the government’s choice over policy instruments emerges. The right way to judge the success of the policy is to ask: 1) have we set up the institutions that create an ongoing conversation with the private sector and the bureaucrats, and 2) can we respond selectively and quickly to the economic opportunities that these conversations are helping identify?
Carrots and Sticks
Industrial policy needs to encourage investments in nontraditional areas (the carrot), but also weed out projects and investments that fail (the stick). It is recommended that incentive programs have conditionality, sunset clauses, built-in program reviews, monitoring, benchmarking, and periodic evaluation. The criteria by which a program will be judged a success must be explicit to effectively distinguish between success and failure and to guard against the tendency to scale down expectations when things do not work out.
An example of bringing the discipline of the market to bear on incentive programs is exhibited by export subsidies. By making incentives conditional on export performance, countries establish the right incentives for firms to enhance productivity. Co-financing is another mechanism to bring in the discipline of markets as it distinguishes between firms that are willing to risk their capital and those that aren’t.
If industrial policy is partly about self-discovery, it is expected that many promoted firms will fail. What is important, therefore, is for the government to let the losers go, not pick winners. Mechanisms that can recognize when things are going wrong and that can phase out the support must be in place.
Accountability
The public deserves to be informed of how decisions are made and why certain activities or firms are favoured. To do this, a person must be appointed to explain why the agenda looks as it does, and to be politically responsible for things that are going right or wrong. Accountability can also be nurtured at individual agencies by giving them clear obligations and then asking them to report and explain any deviations from the targets. Another fundamental tool for accountability is transparency. This can be achieved by publishing the activities of the deliberation councils and holding periodic accounting of the expenditures. Request made by firms for government assistance should also be made public.
Concluding Remarks
Skepticism about industrial policy is grounded on the following views on economic development and bureaucratic capacity:
1. There is little need for governments to resort to industrial policy since what constrains economic development and growth is hardly ever the kind of market failures.
2. Governments do not have the right information that would enable them to target their interventions appropriately.
3. Industrial policy is an invitation to corruption and rent seeking, and it opens the door to preferential policies.
4. It is difficult to empirically prove that industrial policy actually works in practice; most published econometric estimates in fact suggest otherwise.
5. Governments already have their hands full with a wide range of reforms in other areas. They should not be burdened by industrial policies.
These arguments are based on unexamined assumptions about the nature of economic development and the capacity of governments. They overlook the fact that most economies already have industrial policies, even if they do not call them by that name. What analysts don’t realize is that it is possible to design institutional arrangements that achieve social objectives while keeping agency problems in check. Because they have not fully come to grips with this point, the debate on industrial policy is still hung up on the question “should we or should we not?” Policymakers and analysts must understand that industrial policy is just another government task that depends on the growth constraints of a country. Once this point is grasped, it will become easier to plan and implement industrial policies.
Source:
Rodrik, Dani, Normalizing Industrial Policy, paper prepared for the Commission on Growth and Development, (Harvard University, September 2007).
[1] Industrial policy denotes policies that stimulate specific economic activities and promote structural change. Policies targeted at non-traditional agriculture or services qualify as much as incentives on manufactures
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